As tax season approaches, the new Qualified Business Income Deduction (QBI) has been on the minds of many business owners. While we realize some of the information in this letter is heady reading, our goal is to make you aware of changes that may be impacting your business and tax plan.
After reviewing this information, we suggest setting up a time in the next month or so to determine your eligibility for this deduction and discuss strategies to navigate the changes enacted by the Tax Cuts and Jobs Act (TCJA).
Overview – Qualified Business Income Deduction
If you have income from a pass-through entity (or sole proprietorship) you may be entitled to a deduction equal to the lesser of the deductible amount of your qualified business income (QBI) (generally 20% subject to the W-2 wage limitation) or 20% of your taxable income. You may also be able to deduct 20% of your qualified Real Estate Investment Trust (REIT) dividends and qualified publicly traded partnership income. Special rules apply for these additional items. The deduction applies to reduce your taxable income and is available whether or not you itemize. It does not impact your calculation of self-employment tax.
QBI is your net amount of qualified items of income, gain, deduction, and loss with respect to each of your “qualified trades or businesses.” Qualified items are items that are allowed in the determination of your taxable income for the tax year, and are effectively connected with the conduct of a trade or business within the United States or Puerto Rico.
Many items of income, gain, deduction, and loss are not qualified items. These items generally include capital gains and loss, dividends, interest, etc. In the case of a partnership or S corporation, your net amount of qualified items is the net amount your allocable (capable of being allocated or assigned) share of each qualified item. QBI does not include any amount paid by an S corporation to its shareholders that is treated as reasonable compensation, or any guaranteed payment by a partnership to a partner for services rendered with respect to the trade or business. Finally, the IRS may issue regulations providing that any amount paid by a partnership to a partner who is not acting in his or her capacity as a partner for services rendered to the partnership is not QBI. While the former three payment items are not QBI, they may serve to reduce QBI if the entity takes a deduction for these payments. Note that the trade or business of being an employee is not a qualified trade or business and, therefore, no deduction is allowed for your income from the trade or business of being an employee.
If your net amount of QBI from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business in the next tax year and reduces your deduction in a subsequent year (but not below zero) by 20% of any such carryover loss.
Calculation of the deduction is a fact intensive inquiry. If you claim the deduction and you understate the amount of tax required to be shown on your return by 5% or more, you could be subject to the substantial understatement of tax penalty.
If your taxable income does not exceed a threshold of $315,000 (joint filers), or $157,500 (all other taxpayers), your deduction is generally the lesser of 20% of your QBI or 20% of your taxable income.
If your taxable income exceeds the threshold you need to be aware of additional rules.
Is your pass-through income from a “qualified trade or business”?
A qualified trade or business is defined as any trade or business other than a specified service trade or business or the trade or business of being an employee.
A specified service trade or business generally involves the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners (generally, a trade or business where a person receives fees, compensation, or other income, for endorsing a product, use of their likeness or other associated symbols, or appearances on television or other media), or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. If only a small portion of the gross receipts of your trade or business are attributable to one of the listed fields, a de minimis rule may permit you to treat your trade or business as a qualified trade or business.
A specified service trade or business cannot be aggregated with another trade or businesses. While no deduction is allowed for your income from the trade or business of being an employee, a deduction is allowed for your income from a specified service trade or business to the extent that your taxable income does not exceed the threshold amount. However, as your taxable income exceeds the threshold amount, your specified service trade or business income is partially or fully excluded from the deduction. The exclusion phases in based on the ratio of your table income in excess of the threshold amount to $100,000 (joint filers) and $50,000 (all other taxpayers). Thus, no deduction is allowed for your income from a specified service trade or business if your taxable income is more than $415,000 (joint filers) or $207,500 (all other taxpayers).
Application of the W-2 wage limitation
If your taxable income exceeds the threshold amount, the deductible amount of your QBI is equal to the lesser of 20% of your QBI with respect to the trade or business or the W-2 wage limitation. As your taxable income exceeds the threshold above, the W-2 wage limitation phases in and you will reduce the excess amount of your deduction based on the ratio of your table income in excess of the threshold amount to $100,000 (joint filers) and $50,000 (all other taxpayers).
The W-2 wage limitation is equal to the greater of (1) 50% of the business’s W-2 wages, or (2) the sum of (a) 25% of the business’s W-2 wages, plus (b) 2.5% of the unadjusted basis (immediately after acquisition) of all qualified property.
In the case of a partnership or S corporation, you take into account your allocable share of W-2 wages and unadjusted basis (immediately after acquisition) of qualified property for the tax year.
W-2 wages are the total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the tax year of the taxpayer. W-2 wages do not include (1) any amount that is not properly allocable to the QBI as a qualified item of deduction, and (2) any amount that was not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions). Amounts paid to independent contractors are not W-2 wages. If your business uses a third party such as a certified professional employer organization to pay your employees’ wages, you may still be able to include these wages in your W-2 wage calculation subject to certain additional rules.
Qualified property is tangible property of a character subject to depreciation (1) that is held by, and available for use in, the qualified trade or business at the end of the tax year, (2) that is used in the production of QBI, and (3) for which the depreciable period has not ended before the end of the tax year. The depreciable period with respect to qualified property is the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (1) the date 10 years after that date, or (2) the last day of the last full year in the applicable recovery period that applies to the property. The unadjusted basis (immediately after acquisition) of qualified property is determined on the date the qualified property is placed in service.
While we recognize that the issues reviewed above are complex, we nevertheless hope that this information provides a useful introduction to some of the hurdles that may be encountered in calculating your qualified business income deduction.
As a result of the changes made to qualified business income deductions and many more tax law changes created with the enactment of the TCJA, it is very important that we discuss these and various tax planning issues in more detail. Please contact us at 816-858-5959 or firstname.lastname@example.org to discuss the tax law changes and your tax plan.